Revenue Recognition

1
Revenue Recognition

• Herhold, San Jose Mercury News Staff Writer,
  April 26, 2000
• For many in Silicon Valley, the words
  revenue recognition inspire the kind of fear
  and loathing that Mediterranean fruit flies once
  evoked for Californias peach growers.

2
In a Nutshell

• CASH (or receivables)
• REVENUE
• DEFERRED REVENUE (Liability)

3

• FASB - Revenue is usually the largest single item
  in financial statements, and issues involving
  revenue recognition are among the most important
  and difficult that standard setters face. Because
  no comprehensive standards on revenue recognition
  exist, there is a significant gap between broad
  conceptual guidance in the Conceptual Framework
  and the detailed guidance in the authoritative
  literature.

4

• Most of the authoritative literature provides
  industry or transaction-specific implementation
  guidance and it as been developed largely on an
  ad hoc basis and issued in numerous
  pronouncements with differing degrees of
  authority.

5

• The SEC sought to fill the gap in the literature
  with SAB No. 101.
• The SEC staffs view was that the basic criteria
  for revenue recognition were
• Realized or realizable, and
• Earned

6

• Additionally, SAB included additional criteria
  found in SOP 97-2, Software Revenue Recognition
• Persuasive evidence of an arrangement exists
• Delivery has occurred
• The vendors fee is fixed or determinable
• Collectibility is probable

7

• One criticism of SAB 101 is that the criteria in
  SOP 97-2 were developed for a particular industry
  and that the broader application of those
  criteria were neither contemplated nor intended.
• (Why is this an important consideration given the
  process for setting standards at the FASB?)

8

• http//www.fasb.org/project/revenue_recognition.sh
  tml

9
Project Update January 5, 2005

• Objective To develop a comprehensive statement
  on revenue recognition that is conceptually based
  and framed in terms of principles.
• The FASB is partnering with the IASB on this
  project.

10

• As a joint project, the FASB and IASB are sharing
  staff resources and research and are working to
  coordinate the eventual issuance of Exposure
  Drafts and final standards. The Boards are
  coordinating the timing of their deliberations of
  the issues within the joint project, but they
  individually deliberate and vote on those issues.

11
Goals

• Eliminate the inconsistencies in the existing
  authoritative literature and accepted practices
• Fill voids that have emerged in revenue
  recognition guidance
• Provide a conceptual basis for addressing issues
  that arise in the future

12

• Although the Board plans for that Statement to
  apply to business entities generally, it might
  later decide to exclude certain transactions or
  industries requiring additional study

13

• As part of this project, the Board decided to
  reconsider the guidance pertinent to revenue
  recognition in the Concepts Statements.
  Conflicts can arise between the conceptual
  guidance on revenues in CON5 (recognition and
  measurement) and CON6 (definitions)

14

• Those conflicts can arise because revenues are
  defined in CON6 in terms of changes in assets and
  liabilities, but the revenue recognition criteria
  in CON5 do not focus on changes in assets and
  liabilities.

15

• At the October 20, 2004 meeting (a joint meeting
  with the IASB), the Boards discussed how guidance
  in the FASBs Exposure Draft, Fair Value
  Measurements (FVM ED), could be applied in the
  context of measuring performance obligations in
  contracts with customers. In applying the
  principles in the Exposure Draft to certain
  examples that have been previously discussed in
  the revenue recognition project, Board members
  expressed the following tentative views
• In the absence of evidence to the contrary,
  actual exchange prices (in other than active
  markets) should be presumed to be consistent with
  fair value.
• An entity should not be required to consider
  multiple valuation techniques when performing the
  evidence to the contrary test.

16

• In estimating fair values of performance
  obligations, an entity should consider the credit
  enhancement that it provides in the transaction
  (when applicable).
• Prices in proposed exchange transactions may be
  used as market inputs for purposes of developing
  estimates of fair value.
• Fair value estimates of performance obligations
  incorporating significant entity inputs may be
  consistent with the fair value measurement
  objective.

17

• The FASB also discussed but did not agree on
  whether
• Fair values of performance obligations should be
  estimated by reference to the most advantageous
  prices that reflect volume discounts generally
  available to the reporting entity (and to other
  marketplace participants that have a comparable
  volume of transactions), without regard to
  whether the entity chooses to take advantage of
  those volume discounts.
• A proposed price may be used as a market input
  for purposes of estimating the fair value of a
  performance obligation if the entity does not
  have immediate access to the reference market
  from which that price is derived.
• Certain requirements in the Fair Value
  Measurements Exposure Draft (issued June 23,
  2004) might be sufficiently reliable for purposes
  of measuring performance obligations whose
  extinguishment gives rise to revenues.

18

• In some instances, selling revenues arising at
  contract inception might be capable of being
  measured directly and the remaining performance
  obligations may be measured indirectly as the
  excess of the fair value of the entitys rights
  over its selling revenues.

19
Immediate Plans

• Further refine the definition of revenues and
  discuss issues relating to initial and subsequent
  measurement of assets and liabilities
• Continue to develop recognition and measurement
  principles for the general standard
• Explore the operationality of the conceptual
  model at the standards level
• Last summer, the FASB said that in the 4th
  Quarter, 2004, the Board plans to issue an
  Exposure Draft of an amendment to CON5 and a
  separate Exposure Draft of a general standards o
  revenue recognition.
• BUTnow the FASB says

20

• In the fourth quarter of 2005, the Board plans to
  issue a Preliminary Views document covering both
  the concepts- and standards-level revenue
  recognition guidance.

21

• The Board is pursuing an approach that focuses on
  changes in assets and liabilities and is not
  overridden by tests based on notions of
  realization and completion of an earnings
  process. This approach is consistent with the
  definitions of revenues in CON6.

22

• The Board chose the assets and liabilities
  approach rather than the realization approach for
  a number of reasons, including
• Applying the realization and earnings approach to
  revenue recognition in CON5 can lead to conflicts
  with the definitions of assets and liabilities in
  CON6.

23

• This is because, in some instances, those
  approaches involve the recognition of deferred
  debits and deferred credits that do not meet the
  definitions of assets and liabilities (for
  example, unearned revenue). The definitions of
  assets and liabilities are the cornerstones of
  the elements definitions on the conceptual
  framework, as evidence by the defining of
  revenues and expenses in terms of change sin
  assets and liabilities.

24

• Earning and realization have yet to be (and may
  be impossible to be) defined precisely and in a
  manner that can be applied consistently across a
  range of industries and transactions
• It is difficult to identify consistently when
  earnings or realization occurs under
  multiple-element revenue generating arrangements.

25
Recognition of Revenues Working Criteria

• An increase in assets has occurred that increases
  equity, absent a commensurate increase in
  liabilities to the customer or an investment by
  owners.
• An increase in assets occurs when a new resource
  is obtained or created, or an existing resource
  is enhanced.
• The resource embodies future economic benefits
  that are expected to flow to the entity
• The resource is controlled by the entity

26

• An increase in liabilities to the customer occurs
  when a new performance obligation is increased,
• The obligation entails an expected outflow from
  the entity or resources embodying economic
  benefits
• The obligation is owed by the entity to the
  customer.

27

• A decrease in liabilities has occurred that
  increases equity, without a commensurate
  investment by owners (such as the forgiveness by
  owners of a debt owed to them by the entity).

28

• A decrease in liabilities occurs when an existing
  obligation of the entity is diminished or ceases
  to exist by being settled or otherwise eliminated
  other than through transfer to a third party that
  legally assumes it.

29
Measurement Criterion

• The assets or liabilities are measured by means
  of a relevant attribute. The relevant attribute
  for measuring assets or liabilities at initial
  recognition is fair value. Fair value of a
  performance obligation is the price that the
  reporting entity would have to pay a third party
  of similar credit standing to assume
  responsibility for performing those obligations
  (wholesale)

30

• The increase in assets or decrease in liabilities
  is measurable with sufficient reliability. A
  measure is sufficiently reliable when it is the
  most reliable measure available in the
  appropriate reference market. Its reliability is
  assessed based on the definition of reliability
  in CON2 (NRFV)

31
Revenue Recognition

• A reporting entity should not recognize revenues
  for the performance by third parties of its
  obligations to deliver goods or render services
  to customers if those obligations are legally
  assumed by those third parties.

32

• In all other circumstances, a reporting entity
  should recognize revenues for the performance by
  third parties of its obligations to deliver goods
  or render services to customers. Disclosures
  regarding outsourcing and subcontracting
  activities should not be required to be made on
  the face of the income statement, either by
  diaggregating revenues or by means of a line item
  for expenses.

33

• Production can give rise to a component of
  comprehensive income. The Board will discuss
  which component of comprehensive income arises
  from production at a future meeting.
• Nonreciprocal transfers received should not be
  excluded form revenues and should be disclosed as
  a separate line item in the income statement.

34

• A reporting entity should initially measure its
  obligations for performance guarantees at their
  fair values and should recognize revenue from the
  satisfaction or expiration of those guarantees.

35

• The board tentatively agreed that revenues can
  arise as a result of
• A reporting entitys selling activities
• The extinguishment of the entitys performance
  obligations to its customers.

36
Revenue Recognition

• Importance (Lynn Turner, 5/31/01)
• Revenue is typically the single largest item
  reported in a companys financial statements. .
  .reported revenues are not only significant to
  these companies financial statements in dollar
  terms, but also in the weight and importance that
  investors place on them in making investment
  decisions.

37

• Why is revenue so important?

38

• Revenue recognition is an issue that surfaces in
  a significant number of the Commissions
  enforcement cases and is the largest single issue
  involved in restatements of financial statements.
  
• Over half of the financial reporting frauds in
  the COSO (Committee of Sponsoring Organizations)
  report involved the overstatement of revenue

39

• Based on research by Turners office,
  restatements for revenue recognition result in
  larger drops in market capitalization than any
  other type of restatements.

40

• According to the Financial Executives Institute,
  there have been 464 cases of financial statements
  being restated during a recent three-year period,
  which was is more than all the restatements
  during the previous 7 years. Certainly, some of
  the mistakes are honest, and some come from
  mandated changes in response to Levitts earnings
  management initiative.

41

• So it does seem there is a problem!

42
SAB 101

• According to the SEC, SAB 101 is NOT intended to
  be new GAAP, but rather a compendium of existing
  GAAP on revenue recognition.

43
Impact of SAB 101

• According to Turner, approximately 4 in 100
  companies said they made an accounting change to
  comply with SAB 101. Of over 7,000 registrants,
  291 changed their revenue recognition policy.

44

• However, according to Forbes, SAB 101 forces
  companies in a wide swath of industries,
  especially electronics, biotechnology and
  telecommunications, to abandon long-standing
  accounting practices.

45

• And according to CFO Magazine, over 800 companies
  mentioned SAB 101 in their 1999 10Ks and 10Qs
  from the March quarter.

46

• While the SEC claims that SAB 101 is a compendium
  of existing GAAP, Joseph Bronson, CFO of Applied
  Materials, states, This is an accounting change.
  And as such, it should more appropriately be
  drafted by one of the industry accounting
  standards -setting bodies, not the SEC.

47

• Proposals from the FASB are subject to due
  process, in which the proposals are put out for
  public comment and changes can be made based on
  feedback form interested parties. Staff
  bulletins, on the other hand, are simply issued
  by the SEC and expected to be followed.

48

• What do you think of the above statement?

49
4 Underlying Principles in SAB 101

• Revenue is recognized when it is realized or
  realizable and earned as demonstrated when 4
  criteria are all met

50

• Persuasive evidence of an arrangement exists
• Delivery has occurred or services have been
  rendered
• The sellers price is fixed or determinable
• Collectibility is reasonably assured

51

• Ron Mano, an accounting professor at Weber State
  University, published an article in Accounting
  Today. In that article, Professor Mano wrote

52

• I asked my undergraduate class at Weber State
  University what they thought should exist before
  a company recognized revenue. They came up with
  the following list An actual sale of goods or
  services a specified price and the ability to
  collect.

53

• It turned out to be a pretty simple exercise
  because it took them about three to four minutes
  to come up with the list. Two days later, I
  spoke at an Institute of Internal Auditors
  meeting in Salt Lake City. Since the issue fit in
  well with my topic, I did the same exercise with
  that group of professionals. They came up with
  the same list in about the same amount of time.

54

• Next, I went to a faculty colleague and did the
  same exercise. In about the same amount of time,
  he came up with the same list.

55

• Now I ask, Why do we need a formal SEC rule to
  require what several different groups took about
  three minutes each to develop? Could it be that
  there are some problems out there that relate to
  the recognition of revenue? It is regrettable
  when the SEC feels a need to promulgate, as a
  formal rule, that which should be totally obvious
  to even marginally qualified accountants. . .

56

• We accountants need to look at ourselves and how
  we have participated in or even been the
  architects of management fraud. I do not
  criticize the SEC for promulgating the obvious.
  However, it is regrettable that we accountants
  have created or participated in the situation
  where the SEC feels compelled to promulgate the
  obvious.

57

• While these standards might not seem radical, or
  even surprising, they do differ from the common
  practice in some industries, particularly in the
  technology sector.

58

• Mary Barth (Stanford University) notes
  Interpretation of these requirements is where
  this seemingly simple definition becomes more
  complex. Certain industry-specific issues have
  emerged as a result of SAB 101.

59

• Ray Beier, PWC The companies that have been
  the most affected by 101 are the ones in the new
  economy space, because they tend to have
  complicated revenue streams.

60

• According to PWC, These criteria are in many
  cases stricter than the practices certain
  industries have followed for years and their
  adoption has led to some high profile earnings
  restatements. PWC believes that under SAB 101
  form, in some respects, trumps substance, and
  seemingly insignificant contract provisions can
  defer revenues.

61

• So, how does all this relate to fair
  presentation?
• What are some of the underlying issues?

62
Customer Acceptance Clauses

• The SEC assumes that clauses giving customers a
  right to test products or obtain additional
  services from the seller prior to accepting a
  product are bargained-for items, and the seller
  cant recognize revenue until the customer signs
  off or the clause lapses.

63
Upfront Fees

• The SEC staff views upfront fees for services
  delivered over a specified time period to be
  additional payment for those services. Even if
  non-refundable, such fees generally should be
  recognized over the term of the sales agreement,
  not when payment is received. Where fees are
  refundable, they should not be recorded until the
  refund right expires.

64
Multi-phased deliverables

• The SEC does not consider an item delivered until
  the buyer has full use of it. (Is this consistent
  with the concept of title passes?) Thus, when a
  company delivers a product or service in stages,
  such that the undelivered items are essential to
  the functionality of the delivered items, it must
  defer recognition of revenue.

65
Multiple Element Contracts

• Contracts with more than one element require that
  revenues associated with the contract be
  allocated to each element of the contract based
  on fair value. IF revenue cannot be allocated in
  this way to each element, the revenue should be
  deferred and recognized only when all of the
  elements have been met.

66
Example

• Consider a manufacturing equipment sale that
  consists of the equipment, installation, and one
  year of support. The company must be able to
  establish fair value for each element to
  recognize revenue separately on each element as
  it is delivered.

67
Contingent income

• If all or part of the fee a company receives for
  its services depends on the buyers meeting
  performance criteria (such as an ad agencys fee
  contingent on the clients meeting a sales
  target), those criteria must be met before the
  company can record the contingent portion of the
  fee as revenue even if meeting the criteria is
  virtually assured.

68
Contingent Rent

• Consider a leasing company that owns and leases
  retail space. The company as lessor renews an
  operating lease with a clause that requires
  payment of an additional one percent of the
  lessees net sales in excess of a specified
  amount. The lessor should defer recognition of
  this contingent income until specified targets
  that trigger it have been met.

69
Layaway Sales

• Retailers should recognize revenue from sales
  upon delivery of the merchandise to the customer.
  Until then, the amount of cash received should
  be recognized as a liability deposit. Even if
  the company sets a time period during which the
  customer must finalize the purchase and the
  merchandise is set aside in a separate warehouse,
  revenue is not recognized until delivery is final.

70
The Impact

• Valuation Considerations. Companies may alter
  business practices by eliminating things like
  customer acceptance clauses to minimize the
  impact of the new rule and maximize revenue
  recognition

71
Cash Flow

• Some feel that SAB 101 may reduce the cash
  flow-predicting power of GAAP earnings. Since SAB
  101 specifies that the receipt of cash does not
  necessarily equal immediate revenue, to the
  extent that companies are required to defer
  revenue, GAAP earnings will deviate further from
  cash flow, potentially reducing their predictive
  capability and therefore their relevance.

72

• It isnt just tech companies that have been
  affected. The following are statements from SEC
  filings of several well-known companies

73

• Abercrombie and Fitch During the 4th quarter of
  fiscal 1999, the company changed its method of
  accounting for gift certificates, using SAB 101
  as guidance. The effect of the change was a
  noncash reduction of 0.03 per share to the
  companys 1999 diluted earnings.

74

• Kmart In consideration of SAB 101, the company
  has retroactively changed its method of
  accounting for layaway sales effective January
  29, 1999. The company has recorded a
  one-time,noncash, after-tax earnings reduction of
  . . . 0.01 per share in the fourth quarter of
  2000 to reflect the cumulative effect of the
  accounting change.

75

• Sears Roebuck In the year 2000, the company
  will change its method of recording licensed
  business revenue. The change will reduce
  reported revenue and reported expenses, but have
  no impact on operating income.

76

• Walmart During the fourth quarter of fiscal
  2000, the company adopted changes in its method
  of accounting for membership revenue recognition.
  This change was made in response to the issuance
  of SAB 101. . . The effect of the change will be
  a one-time noncash reduction to the companys
  earnings of approximately 0.05 per share.

77

• But certainly the tech sector has been affected
  as well

78

• CFOs in the semiconductor equipment manufacturing
  industry have always recorded sales when their
  products are shipped. Title has passed to the
  customer, and generally, suppliers get paid 90
  percent of the cost within 30 days of shipment.
  The last 10 percent is paid after the equipment
  is installed to the satisfaction of the customer.
  

79

• But SAB 101 says sales shouldnt be booked until
  installation is completed and the company has a
  reasonable expectation of full payment

80

• Shifting the moment of revenue recognition from
  the date the equipment is shipped to the time it
  is installed and essentially paid for would
  deprive the industry of a measure of control over
  the timing of sales.

81

• The chip-equipment makers dislike SAB 101 because
  the process of installing their gear--large,
  sophisticated machinery used in the manufacture
  of silicon chips--can take months or even more
  than a year. Scott Williamson of Chase HQ says
  industry leaders have told him they fear that the
  new revenue-recognition practice could give
  customers more leverage that a customer could use
  to extract concessions.

82

• And AMDs Bronson notes, If I adhere to the
  strict letter of acceptance, the customer could
  determine my revenue stream. Moreover, Bronson
  believes that SAB 101 might increase
  opportunities for earnings management.

83

• Executives could include or exclude sales in a
  period by either expediting or delaying the
  acceptance of its customers. If managers are
  trying to manage earnings, SAB 101 gives us a big
  cookie jar we shouldnt have, says Bronson.

84

• Similarly, biotech companies have to change the
  recognition of up-front fees and milestone
  payments they receive for their development
  contracts. The companies previously recognize
  the payments as revenue when received. Under SAB
  101, they must defer recognition and amortize of
  the life of the agreement.

85

• However, industry representatives argue that
  milestone payments are not contingent on any
  future success of the research or products but
  are made because of the companys past
  performance,and the payments are typically
  nonrefundable.

86
The fear...

• Changing the timing of revenue recognition does
  not change total revenues. There is a one-time
  adjustment to the new standard. But industry
  feared a short-term perception problem because
  its revenues would appear to be weaker for up to
  a year.

87

• And at least in some cases there seems to be a
  basis for the fears...

88
Software

• On March 20, MicroStrategies issued a press
  release announcing it would restate its revenues
  in order to recognize software licensing fees
  over the course of its contract instead of
  upfront. Instead of reported 1999 revenue of
  205.3 million, the company said the restated
  figure was between 150 million and 155 million,
  but noted net cash flow remained unchanged.

89

• Yet in a single day, the stock fell form 226.75
  to 86.75.

90

• There may have been other issues, and it may be
  that the decrease in value was justified. But
  were investors using the information reasonably
  prudent? Can we continue to use this benchmark?
  How should we define our user?

91

• Professional Detailing, a firm that recruits and
  manages sales staffers for drug companies,
  reduced their revenues by 5 after PWC told them
  that the reimbursements it gets from clients for
  placing help-wanted ads could not be included in
  revenues. Within among of when Professional
  Detailing announced the revenue revision, its
  stock was down 31.

92

• Again, net income was unchanged, and cash flows
  were unchanged. Instead of a revenue, it would
  appear the reimbursements would be a recognized
  as a reduction in expense...

93

• Ironically, industry and the SEC appear to fear
  the same thing the erosion of investor
  confidence. They just come at it from different
  angles.

94

• And remember there have been significant abuses
  of revenue recognition...

95

• Cendant, Waste Management, Sunbeam ...just to
  name a few of the more notable frauds centering
  on revenue recognition...

96

• And scores more of less well-known names...

97

• Physician Hospital Services was booking
  revenues not only before mailing the invoices but
  before finishing the work. Their stock price
  dropped 23, and they took a 13.8 million charge
  to fix the mess